Glasner on market monetarism

Monetarism and the Great Depression by David Glasner

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Scott is totally right, of course, to point out that the fall in interest rates and the increase in the real quantity of money do not contradict the “money hypothesis.” However, he is also being selective and unfair in making that criticism, because, in the three slides immediately following the one to which Scott takes such offense, Foote actually explains that the simple IS-LM analysis presented in the previous slide requires modification to take into account expected deflation, because the demand for money depends on the nominal rate of interest while the amount of investment spending depends on the real rate of interest. Here are the slides: 

Thus, expected deflation raises the real rate of interest and causes the IS curve to shift to the left but leaves the LM curve where it was. Thus, expected deflation explains a fall in both nominal and real income as well as in the nominal rate of interest; it also explains an increase in the real rate of interest. Scott seems to be emotionally committed to the notion that the IS-LM model must lead to a misunderstanding of the effects of monetary policy, but Foote actually shows that it can accommodate a correct understanding of the role of monetary policy in the Great Depression. 

The Great Depression was triggered by a deflationary scramble for gold associated with an uncoordinated restoration of the gold standard by the major European countries in the late 1920s, especially France and its insane central bank. On top of this, the Federal Reserve, succumbing to political pressure to stop stock market speculation, raised its discount rate to a near record 6.5%, adding to the pressure on gold reserves, thereby driving up the value of gold, and leading to expectations of further deflation. It was thus a rise in the value of gold, not a reduction in the money supply (and thus no shift in the LM curve), which was the source of the monetary shock that produced the Great Depression. IS-LM is not necessarily the best model with which to describe this monetary shock, but the basic story can be expressed in terms of the IS-LM model. 

So you may be asking yourself why, if I don’t think that Foote’s exposition of the IS-LM model seriously misrepresents what happened in the Great Depression, did I say at beginning of this post that Foote’s slides really annoy me? Well, the reason is simply that Foote seems to think that the only monetary explanation of the Great Depression is that of Milton Friedman: that the Great Depression was caused by an exogenous contraction in the US money supply. That is totally wrong. What caused the Great Depression was an international disturbance to the value of gold, caused by the independent actions of a number of central banks, most notably the insane Bank of France, which was maniacally trying to convert all its foreign exchange reserves into gold, and the Federal Reserve, which was obsessed with the suppression of a non-existent stock market bubble on Wall Street. It was a bubble only because the combined policies of the Bank of France and Fed wrecked the world economy and drove into Depression. The decline in the nominal quantity of money in the US, the great bugaboo of Milton Friedman, was truly an epiphenomenon. But as Ron Batchelder and I have shown, Gustav Cassel and Ralph Hawtrey had already diagnosed and explained the causes of the Great Depression fully a decade before it happened. Unfortunately whenever people think of a monetary explanation of the Great Depression, they think of Milton Friedman, not Hawtrey and Cassel. Scott Sumner understands all this, he’s even written a book – a wonderful book – about it. But he’s gets all worked up about IS-LM. I could not care less about IS-LM, it’s idea that monetary cause of the Great Depression was discovered by Milton Friedman that annoys the [redacted] out of me.